Wage inflation, de-carbonisation and localisation are driving structural inflation, argues Chester Asset Management – and investors need to reposition their portfolios accordingly.
Central bank policy is ultra-loose and will remain so until the US hits full employment, according to Australian equities manager Chester Asset Management – and investors must prepare for an inflationary pulse driven by rising wages.
“Look no further than the Chairman of the US Federal Reserve, Jay Powell, who has consistently maintained that full employment equates to an unemployment rate of 3.5 per cent,” says Chester Asset Management’s Managing Director and Portfolio Manager Rob Tucker.
“Every policy direction in the US – from Biden’s American Jobs Plan to the Fed’s unrelenting desire to pump liquidity into markets – is geared around achieving full employment. There’s a strong desire to create wage inflation, which has been missing for the bottom 60 per cent of the workforce for at least two generations,” says Tucker.
Wage inflation remains the key to structural inflation, according to Tucker, but other elements like de-carbonisation and localisation of supply chains (rather than globalisation) are strong factors too.
“With the Biden’s administration’s stated desire to cut fossil fuel emissions in half by 2030, there is a clear global imperative to get to a carbon neutral position as quickly as possible. That’s going to need capital investment of US$2.8-3.5 trillion per year for the next 20 years, which will add 3-4 per cent to global GDP every year,” says Tucker, citing a Credit Suisse research report.
Another strong driver of structural inflation is the localisation of supply chains, he says.
“Along with increased automation, the globalisation thematic has been one of the driving forces behind the deflationary backdrop of the past 30 years,” says Tucker. “Companies are increasingly trading off the cheaper cost of goods with increased control of supply chains as well as IP security.”
“As a recent example, Intel recently announced a $20 billion investment to build a manufacturing facility in Arizona, which was seen as much as protecting intellectual property as securing supply,” he says.
Cyclical factors are also playing a role in the inflation story, he says, with the inflationary pulse of the economic recovery and accompanying supply chain constraints playing a significant role.
“There’s also the base effect of the oil price more than doubling, while copper and timber prices are also up significantly year on year, which all feed into the cost of manufacturing” says Tucker.
Four strategies to beat inflation
There are four key strategies that investors should adopt in response to the prospect of structural inflation, says Tucker.
- Buy real assets
“In an inflationary environment you want to hold real assets – in other words, things that you can touch. Whereas capital-light growth companies have done well in the current low-interest rate environment, we believe investors should be moving to capital-intensive industries like property, commodities and agriculture,” says Tucker.
“You want assets that are difficult to replicate and difficult to disrupt,” he says.
- Focus on valuation
“If you’re buying equities in this environment, you have to look at valuations. In an inflationary environment, theoretically bond yields rise – and that means the valuation attached to long-duration assets will fall.”
“All else being equal, a 100 basis point rise in the 10-year bond would see a stock on 40 times earnings see its valuation fall by 30 per cent,” says Tucker.
- Look for pricing power
“When there’s inflation you want to be buying companies that can, at a minimum, hold their margins steady. If you have pricing power, you can pass on the rising cost of goods to your consumers, without impacting engagement,” he says.
- Invest in gold equities
“Gold has historically done really well in times of inflation. For us, though, gold has a dual purpose – because in times of inherent volatility gold acts in a non-correlated manner. That’s why we’ve always allocated a portion of the portfolio to gold equities,” says Tucker.